What is an annuity and what do you need to be aware of?

March 17, 2015

What if I told you that you that you could have a guaranteed £500 a month for the rest of your life? What if you could have that money whether or not there was a stock market crash, house price plunge or global debt crisis? What if you gave me most or all of the money you’d saved up over your life, and each month I gave you an agreed amount of money until you died, whether that was in three years or 30 years?

Well, that’s an annuity.

Put on your history caps

Annuities have been around for years. A lot of years. The first income annuities date back to the Roman Empire, where soldiers and citizens would deposit money into a pool in the hope that they’d be able to access some of that money in later life. As part of the deal, the government took a small slice of the pie. Now, if you lived a long time, you got increasing income payments. If you weren’t so lucky, well, you probably weren’t that interested by then anyway – the sword in your belly was somehow more pressing.

In the 1600s, European governments used this same concept to finance things like wars and public projects, keeping a slice of the total deposits in the process.

Feel free to impress your friends with all of this amazing information at your next dinner party. If they walk away bored, it’s their loss. Not yours.

What is an annuity at its simplest?

Annuities in the modern world are underpinned by the same logic as 2000 years ago, although these days, it’s not governments, it’s insurance companies.

An annuity is a contract between you and one of those insurance companies. You give them your money, and they promise you a guaranteed income or return on your money. You can also decide when you start to receive those payments – the longer you wait, the more you get.

These days, there are lots of different types of annuity, so it’s not as simple as it used to be. Annuities have also come in for a lot of criticism, mainly as they currently offer quite low returns for the money that you put in. Still, there are always two sides to the story. Let’s take a look.

Benefits of an annuity

Let’s say you leave all of your money invested in the stock market, rather than buying an annuity. You’ve hit retirement age and BAM! A monumental stock market crash wipes out half of the value of your fund. With a traditional annuity, you don’t have to deal with the uncertainty of stock market ups and downs. Your monthly income is fixed – you traded in your big pot of money for that month-by-month certainty.

Annuities can also be tailored to your needs. For example, you could buy an annuity which allows you to have the income paid to your spouse or partner after you die. You could buy an annuity that sees your income increase every year. You could even guarantee to have your income paid for at least a certain number of years. There are a lot of options, and each option needs careful consideration.

A quick example:

Roughly every £100,000 of pension pot currently buys you an income for the rest of your life of around £3,000 per year. This equates to an annuity rate of 3% and would probably include a spouses 50% pension and possibly inflation increases.

If you decide not to include spouses pension or not have inflation increase, or you have an illness or you smoke, then annuity rates are higher at the moment, possibly 5%, meaning your £100,000 would buy you a pension of £5,000 a year.

The downsides of an annuity

Annuities continue to have a bad press. Some people who invested in annuities in the early 2000s saw their incomes effectively halved as the large insurer from which they’d purchased their product attempted to conserve cash. Ouch.

We’ve also seen annuity rates plummet, as interest rates stay low, bond and gilt yields don’t add up to much, and people live longer and longer.

There is no flexibility in income. You lose the ability for efficient tax planning and an income that can adapt to changing circumstances.

Finally, when you buy the annuity, you lose ownership of your funds, and it can take years to recoup your initial investment.

Going back to our earlier example:

You’ve given the insurance company £100,000 from your pension pot and they’re giving you back £3,000 per year. Just doing the simple maths, you’ll need to live longer than 33 more years to recoup your money.

Assuming most people retire somewhere between 55 and 65, there are going to be quite a few people who don’t live long enough to make their money back. And bearing in mind that the insurance company are getting use of your £100,000 for those 33 years, it starts to look like a much better bet for them than for you.

What are your options at retirement?

It used to be that annuities were the de facto option for people when they began their retirement. These days, especially considering the changes coming in 2015 where you’ll have the freedom to take all your pension pot out in one go should you wish, that’s not the case.

But annuities, which can be more tailored than ever to your needs, remain an option to consider, either for all of your pension pot or part of it. There are upsides and downsides, just like every other approach on the table, but the fact is, this product could give you a guaranteed income for life. And if you’re planning on having a long retirement, that’s a load off your mind.

If it was good enough for Caesar…

 

This article is for general use only and is not intended to address your particular requirements. It should not be relied upon in its entirety and shall not be deemed to be or constitute advice.

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